Intermediate accounting 13th kieso warfield chapter 09

Chapter
9-1


CHAPTER

9

INVENTORIES:
ADDITIONAL VALUATION ISSUES

Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
9-2


Learning
Learning Objectives
Objectives
1.

Describe and apply the lower-of-cost-or-market rule.

2.

Explain when companies value inventories at net realizable
value.

3.

Explain when companies use the relative sales value method to
value inventories.

4.

Discuss accounting issues related to purchase commitments.

5.

Determine ending inventory by applying the gross profit
method.

6.

Determine ending inventory by applying the retail inventory
method.

7.

Explain how to report and analyze inventory.

Chapter
9-3


Inventories:
Inventories: Additional
Additional Valuation
Valuation Issues

Issues
Lower-ofCost-orMarket
Ceiling and
floor
How LCM
works
Application of
LCM
“Market”
Evaluation of
rule

Chapter
9-4

Valuation
Bases
Net realizable
value
Relative sales
value
Purchase
commitments

Gross Profit
Method
Gross profit
percentage
Evaluation of
method

Retail
Inventory
Method
Concepts
Conventional
method
Special items
Evaluation of
method

Presentation
and Analysis
Presentation
Analysis


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
LCM
A company abandons the historical cost principle when
the future utility (revenue-producing ability) of the
asset drops below its original cost.
Market = Replacement Cost
Lower of Cost or Replacement Cost
Loss should be recorded when loss occurs, not in the
period of sale.

Chapter
9-5

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Ceiling and Floor
Why use Replacement Cost (RC) for Market?
Decline in the RC usually = decline in selling price.
RC allows a consistent rate of gross profit.
If reduction in RC fails to indicate reduction in utility,
then two additional valuation limitations are used:

Chapter
9-6



Ceiling - net realizable value and



Floor - net realizable value less a normal profit margin.

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Illustration 9-3

What is the rationale for the
Ceiling and Floor limitations?

Cost
Cost

Market
Market

GAAP
GAAP
LCM
LCM
Chapter
9-7

Ceiling = NRV
Not
>

Replacement
Cost
Not
<

Floor =
NRV less Normal
Profit Margin

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Rationale for Limitations
Ceiling – prevents overstatement of the value of
obsolete, damaged, or shopworn inventories.

Floor – deters understatement of inventory and

overstatement of the loss in the current period.

Chapter
9-8

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
How LCM Works (Individual Items)
Illustration 9-5

Chapter
9-9

Solution on
notes page

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Methods of Applying LCM
Illustration 9-6

Chapter
9-10

Solution on
notes page

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Recording LCM

(data from Illus. 9-5 and 9-6)

Ending inventory (cost)
415,000
Ending inventory (LCM)
350,000
Adjustment to LCM
Loss on inventory
Allowance

Allowance
65,000
Method
Allowance on inventory
Method
65,000
Direct
Direct
Method
Method
Chapter
9-11

Cost of goods sold

$

$
65,000

65,000

Inventory
65,000
LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Balance Sheet Presentation

Chapter
9-12

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Income Statement Presentation
Sales

Allowance
$

Cost of goods sold

300,000

Direct
$

300,000

120,000

185,000

180,000

115,000

Selling

45,000

45,000

General and administrative

20,000

20,000

Total operating expenses

65,000

65,000

65,000

-

Gross profit
Operating expenses:

Other revenue and expense:
Loss on inventory
Interest income

5,000

Total other

5,000

(60,000)

5,000

Income from operations

55,000

55,000

Income tax expense

16,500

16,500

Net income
Chapter
9-13

$

38,500

$

38,500

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
P9-1: KC Company manufactures desks. The company attempts to
obtain a 20% gross margin on selling price. At December 31, 2010,
the following finished desks appear in the company’s inventory.

Instructions: At what amount should the desks appear in the
company’s December 31, 2010, inventory, assuming that the company
has adopted a lower-of-FIFO-cost-or-market approach for valuation
of inventories on an individual-item basis?
Chapter
9-14

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Ceiling = 450
(500
(500 –– 50)
50)

Not
>

Cost
Cost == 470
470

Market
Market == 450
450

Replacement
Cost = 460
Not
<

Floor = 350

LCM
LCM == 450
450
Chapter
9-15

(450-(500
(450-(500 xx 20%))
20%))

LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Ceiling = 480
(540
(540 –– 60)
60)
Not
>

Cost
Cost == 450
450

Market
Market == 430
430

Replacement
Cost = 430
Not
<

Floor = 372

LCM
LCM == 430
430
Chapter
9-16

(480-(540
(480-(540 xx 20%))
20%))

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Ceiling = 820
(900
(900 –– 80)
80)
Not
>

Cost
Cost == 830
830

Market
Market == 640
640

Replacement
Cost = 610
Not
<

Floor = 640

LCM
LCM == 640
640
Chapter
9-17

(820-(900
(820-(900 xx 20%))
20%))

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Finished Desks
Inventory cost
Est. cost to manufacture
Commissions and disposal costs
Catalog selling price

Cost
Cost == 960
960

D
$ 960
1,000

130
1,200

Ceiling = 1,070
(1,200
(1,200 –– 130)
130)
Not
>

Replacement
Cost = 1,000
Market
Market == 1,000
1,000

Not
<

Floor = 830

LCM
LCM == 960
960
Chapter
9-18

(1,070-(1,200
(1,070-(1,200 xx 20%))
20%))

LO 1 Describe and apply the lower-of-cost-or-market rule.


Lower-of-Cost-or-Market
Lower-of-Cost-or-Market
Evaluation of LCM Rule
Some Deficiencies:
Expense recorded when loss in utility occurs. Profit on sale
recognized at the point of sale.
Inventory valued at cost in one year and at market in the
next year.
Net income in year of loss is lower. Net income in subsequent
period may be higher than normal if expected reductions in
sales price do not materialize.
LCM uses a “normal profit” in determining inventory values,
which is a subjective measure.
Chapter
9-19

LO 1 Describe and apply the lower-of-cost-or-market rule.


Valuation
Valuation Bases
Bases
Net Realizable Value
Permitted by GAAP under the following conditions:
(1) a controlled market with a quoted price applicable to
all quantities, and

(2) no significant costs of disposal (rare metals and
agricultural products)

or
(3) too difficult to obtain cost figures (meatpacking)

Chapter
9-20

LO 2 Explain when companies value inventories at net realizable value.


Valuation
Valuation Bases
Bases
Relative Sales Value
Used when buying varying units in a single lump-sum purchase.
E9-7: Larsen Realty Corporation purchased a tract of unimproved land
for $55,000. This land was improved and subdivided into building lots at
an additional cost of $30,000. These building lots were all of the same
size but owing to differences in location were offered for sale at
different prices as follows. Operating expenses allocated to this project
total $18,200.
Instructions: Calculate
the net income realized
on this operation to
date.

Chapter
9-21

LO 3 Explain when companies use the relative
sales value method to value inventories.


Valuation
Valuation Bases
Bases
E9-7 (Relative Sales Value Method - Solution)
x

x

Chapter
9-22

=

x

=

=

LO 3 Explain when companies use the relative
sales value method to value inventories.


Valuation
Valuation Bases

Bases
Purchase Commitments
Generally seller retains title to the merchandise.
Buyer recognizes no asset or liability.
If material, the buyer should disclose contract details in
footnote.
If the contract price is greater than the market price,
and the buyer expects that losses will occur when the
purchase is effected, the buyer should recognize losses
in the period during which such declines in market prices
take place.
Chapter
9-23

LO 4 Discuss accounting issues related to purchase commitments.


Valuation
Valuation Bases
Bases
Illustration: St. Regis Paper Co. signed timber-cutting
contracts to be executed in 2012 at a price of
$10,000,000. Assume further that the market price of
the timber cutting rights on December 31, 2011, dropped
to $7,000,000. St. Regis would make the following entry
on December 31, 2011.
Unrealized Holding Gain or Loss—Income

3,000,000

Estimated Liability on Purchase Commitments
3,000,000

Chapter
9-24

LO 4 Discuss accounting issues related to purchase commitments.


Valuation
Valuation Bases
Bases
Illustration: When St. Regis cuts the timber at a cost of
$10 million, it would make the following entry.
Purchases (Inventory)

7,000,000

Estimated Liability

3,000,000

Cash
10,000,000
If Congress permitted St. Regis to reduce its contract price
and therefore its commitment by $1,000,000.
Estimated Liability

Chapter
9-25

1,000,000

Unrealized Holding Gain or Loss—Income
1,000,000
LO 4 Discuss accounting issues related to purchase commitments.